Archive for March 7th, 2008

This is a hot topic of discussion- limiting the huge salaries of investment managers. It was started by Raghuram Rajan and I had mentioned earlier we should see some research on this topic.

I came across this excellent paper from Dean Foster and Peyton Young . Foster is a Statistics prof from Wharton and has taken a lot of interest in finance especially to show that it is not skill but good luck that leads to huge returns. I have pointed out to his superb paper on the same here

Now coming to the main paper. The abstract says it all:

This paper examines theoretical properties of incentive contracts in the hedge fund industry. We show that it is very difficult to structure incentive payments that distinguish between unskilled managers, who cannot generate excess market returns, and skilled managers who can deliver such returns. Under any incentive scheme that does not levy penalties for underperformance, managers with no investment skill can game the system so as to earn (in expectation) the same amount per dollar of funds under management as the most skilled managers. We consider various ways of eliminating this “piggyback effect,” such as forcing the manager to hold an equity stake or levying penalties for underperformance. The nature of the derivatives market means that none of these remedies can correct the problem entirely.

The paper explains how the hedge fund manager can structure the derivative contracts which will make him appear as a skilled fund manager but in reality he is unskilled or even an ‘outright con artist’. Foster had also explained the paper in an article which I covered here.

The main thought is:

There are two separate problems that a properly designed incentive scheme needs to address. The first is how to align the interests of the manager and the investors more closely. The second is how to distinguish between skilled and unskilled managers. The former is the alignment problem whereas the second is the separation problem.The authors say structuring the incentives could take care of alignment problem but separation problem would remain.

They structure the incentives in three ways:

1) payments based on final returns
2) forcing the manager to have an equity stake
3) levying penalties for underperformance

And in all three the conclusion is the same- you can’t seperate the skilled from unkilled and latter can easily piggyback on former.

The conclusion is:

First, it is extremely difficult for investors to tell whether a given series of excess returns was generated by superior skill, by mere luck, or by duplicity. Second, because it is easy to fake excess returns and earn a lot of money in the process, mediocre managers and con artists could be attracted to the market. The situation is analogous to an automobile ‘lemons’ market with the added feature that ‘lemons’ can be manufactured at will .

Indeed, it is analogous to a car market with the following characteristics: i) every car is one of a kind; ii) the car’s engine is locked in a black box and no one can see how it works (it’s not protected under patent law); iii) anyone can cobble together a car that delivers apparently superior performance for a period of time and then breaks down completely.

In such a case one would expect the price of cars both good and bad – to collapse, because buyers cannot tell the difference between them. A similar fate may await the hedge fund industry unless ways are found to make their functioning more transparent.

This is a superb paper and the findings can be applied in other types of investment business as well- mutual funds, pension funds etc. Though, the hedge funds are unregulated entities and the effect would be more for them. But still we can’t ignore the findings.